From M. Barton Waring:
May I congratulate you on an extremely well-written and well-presented discussion of basic pension plan valuation mathematics, in the excerpt that you sent me. I don’t think I could have written it so cogently myself; you have absolutely captured the essence of the issues. You are absolutely correct in pointing out that if the pension beneﬁts are supposed to be free of risk of default in their payment, the discount rate used to value the liability for funding should be a risk-free rate, usually taken as the interest rate paid on long term US government bonds—which if owned by the fund would hedge the liability against nearly any risk of failure. As you point out, that doesn’t mean that you must invest in such bonds—but to the extent that you don’t but instead invest in more risky assets such as equities, hedge funds, and other alternatives, the fund is taking the risk that a disappointing average return on investment over an extended period may leave the plan partially insolvent and unable to guarantee its beneﬁt payments.
An example of such an extended period of dramatic disappointment is in recent memory—for the 12 years inclusive of 2000 through 2011, the S & P 500 only averaged 0.5%—just one half of one percent—per year, all while most plans were discounting assuming rates from 5% to 8%. This shortfall in by far the largest pension asset class, for 12 years, led in turn to a massive shortfall in asset values, the principal contributor to today’s widespread pension problems. Had the plans been discounting all the time at appropriate low risk-free rates, the assets would have been far larger to start this period, and the damage would not have been nearly so great.
Good luck to you and the others involved with this plan; you’re on exactly the right path, but it is diﬃcult to persuade people to change, especially when it feels like absorbing bad news. No one wants to see their beneﬁts go down, and equally no one wants to make larger contributions. But those are the only two levers that you have that have the real power to ﬁx the problem. So far, it sounds like your plan, like most plans, has been taking the route of “reaching for returns,” by going into more risky investments. That only works to the extent that those more risky investments in fact pay oﬀ—but for most, they have in fact simply been more risky rather than more rewarding, generating further losses. Reaching for returns is not the answer; the returns are likely to disappoint. Your board needs to tackle the real problems, the size of promised beneﬁts for current and future retirees, vs the available budget for contributions—using proper discount rates. This is tough going, unhappy work—but it is tough love that is necessary if the plan is to survive. Survival will be the reward. Right now, beneﬁts have been promised that can’t be paid for on the contribution budgets that were imagined to be suﬃcient based on discount rates that were too high, and this is unsustainable.
I see that you mention my book. It should be required reading for all pension trustees and all union and employer representatives. And even more importantly, for all actuaries—they are uniformly in denial that their interest rate methods are in error. I guess they just don’t want to accept their responsibility for guiding the country’s pension plans so far into the hole: Hard to blame them; few of us are quick to accept responsibility for minor debacles, much less such major ones. Sadly, most actuaries don’t actually know anything about proper ﬁnance or about ﬁnancial economics despite their urgent contrary protestations—if they did, we wouldn’t be in this mess, using high discount rates. But–show me an actuary that actually has a real background in economics and proper ﬁnance, and I’ll show you an actuary that agrees with me completely. The actuarial profession is slowly changing at the leadership level on this point—but against strong resistance from actuaries in the ﬁeld working with clients.
M. Barton Waring, ﬁnancial economist
August 2, 2017
From Ronald J. Ryan
Your paper is quite correct on discount rates. It is the single largest factor aﬀecting the funding status of pensions. To use the rate-of-return on assets as the discount rate is the major cause of the problems which I feature in my book The U.S. Pension Crisis. The best approach to discount rates is to use the U.S. Treasury STRIPS yield curve as you so noted. The proper discount rates should be risk-free zero coupon bonds. Only zero-coupon bonds have a known future value. Only Treasury STRIPS exist as a risk-free yield curve. Congratulations on your accurate insights.
The objective of a pension is to fund beneﬁt payments (i.e. liabilities) in a cost eﬃcient manner. It is not a return objective. Since we do not know the future value of most assets, the funded ratio and funded status is based on the present value of assets vs. liabilities. To calculate the present value of liabilities we need to use discount rates that can settle (or defease) the liabilities. Only market rates can be purchased to settle liabilities. All other discount rates are accounting ﬁction and will distort economic reality. The diﬀerences in present value can be quite large. In the case of using the rate-of-return as the discount rate, the funded ratio and funded status can be 40% to 60% overstated. This has led to inappropriate asset allocation, beneﬁt and contribution decisions—it all links. Since liabilities are a term structure of beneﬁt payments only a yield curve of market rates should be used as the discount rates. Based on this yield curve of market discount rates, a single discount rate can be calculated that equates to the same present value for accounting purposes but is not a purchasable rate useful for asset management.
Ronald J. Ryan, CEO & Founder, Ryan ALM
July 31, 2017